Why AIG matters

By Elizabeth Strott

After a weekend in which Wall Street seemed to be melting down, investors' worries turned this week to insurance giant American International Group (AIG, news, msgs).

Credit ratings companies Standard & Poor's, Moody's Investors Service and Fitch Ratings all downgraded AIG shares after the close of trading Monday, leaving the insurer scrambling to find capital and stave off insolvency.

While that move sent shudders through the markets once more on Tuesday, an outsider could be forgiven for asking why an insurance company is so critical to the financial markets.

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The problem is that AIG has been selling insurance against the very calamity that is now engulfing the markets. Some of that insurance took the form of credit-default swaps on mortgage-based securities, a transaction in which AIG basically guaranteed the income stream from the mortgage securities. (That isn't the company's only exposure, but it is an important one.) In the event of a substantial default, AIG is obligated to pay the buyers of the swaps.

Worries about liquidity

Monday's downgrades called out worries about AIG's liquidity, in essence questioning its ability to pay in case of defaults.

"The main reason for the rating actions is the combination of reduced flexibility in meeting additional collateral needs and concerns over increasing residential-mortgage-related losses," explained Standard & Poor's credit analyst Rodney Clark.

But the downgrades actually compound the problem by changing the collateral requirements for the financing AIG provides and by allowing AIG's trading partners to elect early termination of financing agreements, which could set in motion a domino effect, adding even more pressure.

"If they don't get a bridge loan, either from the private sector or the Fed, or there's a sudden appearance of wealth funds . . . and if the rating agencies don't give them breathing space, then there's no alternative" to bankruptcy, Hank Greenberg, former chairman and CEO of AIG, said in an interview with Maria Bartiromo on CNBC.

"And that would be a disaster," the former chief continued. "If AIG declared bankruptcy, it's going to be systemic. For the counterparties, they're going to have to unwind that transaction, get in line with everyone else. It could take years."

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AIG's situation also raises broader questions about the stability of the markets, because the company is the world's biggest insurer and does business in nearly every country. If AIG goes under, the failure will have ripple effects around the globe.

"If AIG is not resolved (Tuesday) morning, then when do we stop this?" Paul Mendelsohn, chief investment strategist at Windham Financial Services, told MarketWatch.com. "The assets they would have to shed are mind-boggling. We can't let this thing fail. They take everything with it."

Risk to the system

"In my opinion, the issue of systemic risk is greater at AIG for a number of reasons. First of all, they're an insurance company, and policyholder obligations need to be met first. They take precedence over debt and equity holders," explained Cathy Seifert, equity analyst at Standard & Poor's. S&P's equity department operates separately from the ratings business."Second, AIG is a counterparty with many other financial institutions. The failure of AIG has the potential to cast a wider swath across the financial-services landscape. It's a wider and broader impact.

"I think that they are racing against the clock, and I think that there are assets there, and there is some value to the assets. If they can't realize an adequate fair value to the assets, their options are becoming fewer and fewer," Seifert said.

New York Gov. David Paterson told CNBC on Tuesday morning that AIG has a day to get a deal done. "Right now, we're in a terrible situation if we let the world's largest insurer go down." The New York Federal Reserve is reportedly holding a meeting to discuss the fate of AIG.

The Federal Reserve on Monday rejected AIG's request for a $40 billion bridge loan, instead reportedly asking Goldman Sachs (GS, news, msgs) and JPMorgan Chase (JPM, news, msgs) to help raise $70 billion to $75 billion in short-term financing to help AIG survive.

Since helping rescue Bear Stearns in March and taking over Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) earlier this month, the Fed and the Treasury Department have been wary of continuing to step in and bail out companies, citing a "moral hazard" worry (essentially saying companies that made bad decisions on risk should pay the price).

But AIG is a different situation, according to Tony Crescenzi, chief bond market strategist at Miller Tabak.

"We recognize in the markets that the Fed wants to draw a line in the sand in cases like this," Crescenzi told CNBC last night. "We really do have to think about crossing that line again and sending out a lifeline to AIG if it looks like there will be broad-based repercussions."